A trust is a relationship where one person (the settlor) gives property to another person (the trustee) to manage on behalf of still other people (the beneficiaries). It is designed to hold and/or pass on family property.
A family trust usually serves at least one of two purposes:
- It can reduce a family’s taxes by shifting income to members in lower tax brackets.
- It can provide for less fortunate (or more impulsive) members by controlling how their money is disbursed.
An estate freeze is an example of shifting some income to family members in lower tax brackets and can be an effective estate planning tool
In the first step of an estate freeze owners of a growing company convert their shares of the existing business into preferred stock equal to the current value of the business. The second step is to sell new common stock to the family trust that capture the company’s future growth.
The owners can prepare for the tax liability when they die without worrying about having to sell the company. The next generation can share in the company’s profits through dividends allocated to the common shares.
Limitations of a trust
A trust is not a legal entity and cannot
- Enter into contracts
- Incur liability
A trust is also not a contract that enforces obligations between any of the parties. However a beneficiary may sue a trustee for failing to act in the beneficiary’s best interest.
Tax law with respect to trusts is complex and anyone interested in setting up a trust should talk to a lawyer before proceeding.
Two kinds of trusts
Testamentary trusts are created as part of a will and take effect upon the death of the testator. Recently Canadian law has changed taking away the tax advantage of setting up long-term testamentary estate trusts. As a result they have become less useful.
The other kind of trust is a living, or inter-vivos, trust. A living trust can be established for a variety of purposes and the Canada Revenue Agency (CRA) recognizes many types of living trusts designed for a variety of different beneficiaries.
A list of these types of living trusts can be found on the Government of Canada website. If you are considering a trust, refer to this site to learn more about which of these may apply to your situation
Trusts and tax
A trust is a taxpayer under Canadian law and taxes are applied at the highest marginal rates. As a result trustees try to pass on any income earned by trust property to beneficiaries so they can pay the taxes at their own rates which are often lower than the rate the trust pays.
Keep in mind that Canadian tax law attributes trust income to the person who transferred the property to the trust if the recipients are close relatives – usually a spouse or a child under the age of 18.
These are referred to as attribution rules and don’t apply when the beneficiary is an adult child, grandchild, niece or nephew
There are other attribution rules to consider making it important to consult an estate planning lawyer and/or account before proceeding.
Trustees & Settlors
A transferor can’t control the property in a trust therefore he or she can’t be a sole trustee. There can be a sole trustee or multiple trustees. This is another point of discussion to bring up with your lawyer.
\the person who is transferring the property that is to be put into trust asks someone else to be the settlor, often a relative or close family friend. However there are times when you must appoint someone else, such as a trust company, as a trustee. Establishing a trust in another province is one example. Another time to appoint an outside trustee are when you anticipate conflict within the family.
Transferring Property to a Trust
A trust only exists if some property being transferred or settled. Given the attribution rules, think carefully about settling a trust with property that will provide income or capital to the beneficiaries. Making the decision more difficult is that fact the legitimacy of the trust could be challenged if the assets transferred have not value. Some suggest using a silver or gold coin that is easily identified and has value. This can then be kept in a safety deposit box.
Other strategies that can be employed to facilitate the establishment of the trust include using a prescribed interest rate loan from the settlor.
When new common shares are issued for the purpose of an estate freeze, a small loan can be taken at the prescribed interest rate by the trust to pay for the newly issued common shares. Because most of the value is held in the preferred shares, the value of the common shares could be a nominal amount such as $100. When the trust receives its first dividend cheque, it can repay the loan.
Jamie Golombek of CIBC Wealth Advisory Services has created an excellent document that outlines other features of a trust not listed here. You can read it at In Trusts We Trust: Tax and Estate Planning Using Inter Vivos Trusts
Because of the many issues and options surrounding trusts including complex attribution rules involving tax it is strongly suggested that you talk to a lawyer before setting up a trust.